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Debunking Myths About Emerging Markets Equities

Few asset classes have garnered more attention over the past fifteen years than emerging markets.  The asset class rose from relative obscurity in the 1980s and 1990s to become one of the trendiest, highest flying areas of the market in the early 2000s only to collapse back to earth in subsequent years.  While emerging markets equities may well deserve a place in client portfolios, some of the most commonly cited reasons to own emerging markets do not hold up to empirical evidence.

Myth One – Emerging markets are attractive due to higher than average GDP growth rates.

Academics have researched the correlations between high GDP growth and equity returns in great depth, and the results are surprising.  In 2002, three London Business School professors released an outstanding book entitled Triumph of the Optimists.  One of the themes of the book is that there is effectively no correlation at all between a country’s high growth rate and its equity returns.  In fact, the correlation is virtually zero.  Furthermore, the real returns of the lowest growth countries are virtually even with the returns of the highest countries over the past 45 years.  There may be excellent reasons to invest in emerging markets, but higher GDP growth is not one of them.

Myth Two – Emerging market equities offer superior risk, return and diversification benefits.

Source: Morningstar and Monticello Associates

As the following graph illustrates, U.S. stocks and emerging markets had almost identical returns over the 30-year period since EM’s inception in 1988.  However, when a measure of risk (volatility) is incorporated in the right-hand axis, the risk in EM has been almost 70% higher. Thus, to generate approximately the same return investors have had to commit to much greater volatility.

Another factor investors consider when investing in developing countries is the diversification benefit. When emerging markets were launched in 1988 their correlation to U.S. stocks could often be under 50%, which is advantageous. However, over the past fifteen years the correlation between the MSCI EM and the S&P 500 has averaged 70%. In an overall portfolio, there isn’t a large diversification benefit from owning an asset class with a 70% correlation to the S&P 500, especially one with 70% higher volatility.

 

 

Myth Three – Emerging markets offer investors much greater inefficiencies and, consequently, an easier road to outperformance. 

median-manager
Source: Morningstar and Monticello Associates

Many investors are attracted to emerging markets equities due to their perceived inefficiencies. The index is large and the dissemination of information among investors is not nearly as tight and pervasive as it is in the developed world. Consequently, emerging markets must provide tremendous opportunities for stock pickers or fundamental based investors. However, the data seems to suggest that the opposite may be true.

As the graph above shows, the median EM manager trails the MSCI EM Index for all time periods shown from ten to twenty years. Additionally, the spread between the twenty-fifth percentile and the seventy-fifth percentile of funds is less than two percent. In the case of emerging markets, not only does the average manager tend to under-perform, but the spread between the best and the worst performers is tight. Thus, there is a lower probability of selecting individual managers that outperform, and if managers do generate outperformance, it will likely be by a small amount.

Myth Four – Emerging market equities offer investors compelling opportunities to capitalize on investment fundamentals.

Source: Bloomberg and Monticello Associates
Source: Bloomberg and Monticello Associates

While the underlying fundamentals play an important role over the long term, we have observed that macroeconomic and technical factors can dominate returns in the short to medium term.  As you’ll note in the graph below, there is an inverse relationship between the U.S. dollar and EM equities. Significantly, there has not been a single sustained period in history since the inception of the MSCI EM when emerging market equities have outperformed in a strong dollar environment.

In addition to the U.S. dollar direction, emerging market equities seem to be greatly influenced by U.S. retail investor mutual fund cash flows. It’s important to remember that in almost all emerging markets there is a distinct lack of a domestic investing class.  Consequently, that leaves developing countries enormously vulnerable to the cash flow decisions of foreign investors. Starting in 1996, every single sharp drawdown in emerging market equities has been accompanied by selling by foreign investors.  The relationship between EM mutual fund cash flows and investment performance at times is so strong that it’s led us to believe that emerging market equity performance can be much more technical in nature, i.e. dependent on fund flows, than fundamental, i.e. the growth in a company’s earnings per share.

Multi-nationals in emerging markets — a better alternative?

While institutional investors were denied the opportunity to invest broadly in emerging markets until 1988, individual western companies have been building their businesses in the developing world for over one hundred years.  Nestlé, Colgate-Palmolive and Unilever, all well-known multi-national companies, share an extensive history in virtually every corner of the developing world and these companies now receive more than 50% of their sales from emerging markets, effectively rendering them as de facto emerging market companies.

All three companies show considerable outperformance when compared to the MSCI EM Index. Colgate’s return is almost 40x, while Nestlé and Unilever have returned close to 25x. The MSCI EM Index has had credible performance during this period, returning almost 11% and producing a cumulative return of almost 10x.  Investor’s often overlook investing in something as sleepy as Colgate-Palmolive – after all finding the next hot company in Burkina Faso is much more exciting. However, it’s difficult to deny that compounding shareholder returns at 11% – 15% for almost forty years is compelling, and it’s led to substantial cumulative returns.

Conclusion

We are certainly not writing to recommend that investors shed themselves of emerging market holdings at this point in time. That decision would be too easy. Flows out of EM funds were dramatic last year and the U.S. Dollar has displayed unprecedented strength in the past eighteen months, appreciating against virtually every currency in the EM world. As discussed, EM equities are enormously vulnerable to these two macro trends and, having suffered through a rough patch of performance, you’d have to think the dollar will eventually reverse its course and fund flows will once again become positive. While we are not certain of the timing of these dynamics, we are certain they will happen, as they’ve never not happened, and investors will once again see out-sized returns.

Instead, we believe investors should focus on owning the right type of emerging market equities. The reason that Colgate, Nestlé, and Unilever have performed so well for such a long-time is that they are consumer product companies capitalizing upon opening new markets, which are dependent upon per capita income growth. It is our opinion that easily the greatest strength of the developing world is rising annual incomes. It is stunningly powerful and should continue for decades in its determined march upward.  The demographic advantages present in emerging markets are massive and will provide investors with substantial opportunities over the next three decades. Utilizing an approach that combines multi-national American and European companies with emerging market managers capitalizing upon these local consumer trends makes sense. While the history of emerging markets has been modestly disappointing, it hasn’t been a failure and now, certainly, is not the right time to exit. Additionally, the performance of large multi-national companies benefiting from their presence in the developing world has been spectacular – the blueprint for success is clearly there.

 

Investing in Public Equities: Active or Passive?

During the past five years, we have witnessed a dramatic shift in the way that investors are accessing the capital markets.  The proliferation of Exchange Traded Funds (ETFs) and similar products has provided new avenues through which investors can gain exposure to equities, bonds, commodities and a host of other assets.  The growth of such products, which usually track a passive market index, has largely come at the expense of actively managed mutual funds.  In fact, since 2009, investors have pulled nearly $500 billion from active U.S. equity mutual funds and invested a similar amount into passive ETFs.

In light of this trend, many of our clients are asking whether they should abandon their actively managed equity strategies in favor of lower cost products that simply track the market.  At Monticello, we believe that indexing is an excellent strategy for most investors.  It’s no secret that the majority of actively managed equity funds trail their respective benchmarks because of a combination of high fees and trading costs.  And the picture is even worse for taxable investors.  The fact is that the choice of whether to invest in equities and how much is far more important than the choice of whether to invest actively or passively.  This is because beta tends to dominate total returns, especially over the long-term.  However, for the patient, long-term oriented investor, the rewards of a successful active management program can be substantial, as small incremental returns can lead to significant wealth creation over time.

Source: Morningstar and Monticello Associates
Source: Morningstar and Monticello Associates

Over the past decade, academics have spent considerable time on the issue of active management. Two professors affiliated with Yale University, Martijn Cremers and Antti Petajisto, seem to have made the most progress on understanding why certain active managers outperform. They concluded that investment managers who have the highest Active Share, defined as the percentage of a portfolio that does not replicate an index, have the greatest probability of outperforming the index. This makes intuitive sense as well: the best way to outperform the index is to not be the index.

The problem for investors is that concentration produces a much higher tracking error (i.e. deviation from the benchmark). A low tracking error can often mean closet indexing and a high tracking error, although greatly increasing the odds of market beating outperformance over the long-term, can try the patience of investors in the short-term.

This is a subject that we’ve spent a considerable amount of time researching at Monticello and the end result is somewhat surprising. For the 25-year period ending December 31, 2014, there have only been 70 mutual funds in the Morningstar U.S. Large Cap category that have beaten the S&P 500 Index. These 70 funds have beaten the index by approximately 1% on average. However, the average fund in this select group only outperformed the index about 60% of the time on a rolling five-year basis. That’s right, the 70 funds that outperformed the index for the lengthy time period of twenty-five years spent 40% of all rolling five-year periods underperforming.

We performed another study which looks at actual active managers our clients have employed during the past twenty years. We identified seven highly pedigreed firms that substantially outperformed the S&P 500. Over the 20-year period, ending December 31, 2014, these firms earned on average, an 11.6% per annum return, outperforming the index return of 9.9% by 170 basis points per year. If an investor placed $10 million in the S&P 500 Index on January 1st, 1995, the investment would have grown to $66 million by the end of 2014. On the other hand, if the investor placed the capital with the seven firms we studied, the initial $10 million investment would have grown to $89 million on average. Obviously, that’s a pretty big difference and probably worth fighting for.

However, the seven active firms spent considerable time underperforming over short to intermediate periods. In fact, they only outperformed on average in 76% of the rolling five-year time periods, underperforming in almost one-quarter of the five-year periods. So, in order to generate 1.7% of outperformance over two decades, mostly by concentrating and not replicating the index, investors had to underperform for a number of five-year periods. For many equity investors that’s tough to stomach, hence the attraction of indexing.

graphs2

Source: Morningstar and Monticello Associates

It is this factor that makes active management emotionally difficult for investors, as they hate to tolerate underperformance. In this case underperformance happens for a specific reason: portfolios are designed to own higher quality assets than the index by concentrating their bets. It is this strategy that has the best chance to outperform over the longer term. However, it can prove frustrating to investors as performance can lag, leading to termination right before a sustained period of outperformance.

The key lesson from these studies is that patience is an absolutely essential ingredient for success with active management. Investors must be willing and able to tolerate underperformance, often for long periods of time, in order to reap the rewards of active management. This is easier said than done, and investors would be far better off sticking with a plain vanilla index fund than abandoning an underperforming active manager at exactly the wrong time. As a result, active management certainly isn’t for everyone, but when applied successfully it can lead to substantial long-term rewards for the patient investor.